• New Tax Law Limits Offshore Deferred Compensation
  • October 13, 2008 | Authors: Bruce J. Wein; Joseph A. Hugg
  • Law Firms: DLA Piper - New York Office ; DLA Piper - Boston Office
  • The recently enacted Emergency Economic Stabilization Act contains a tax provision that will prevent hedge fund managers and others from deferring taxes on compensation payable by an offshore corporation organized in a tax haven.

    This new deferred compensation rule generally applies to compensation for services performed after December 31, 2008. Deferrals for 2008 and earlier years, however, will eventually be taxed if not paid out by the end of 2017 (as described below).

    When the new law becomes effective, a service provider will be subject to US federal income tax on deferred compensation payable by a “nonqualified entity” as soon as the compensation is not subject to a substantial risk of forfeiture. A “nonqualified entity” is any foreign corporation unless (a) substantially all of the corporation’s income is subject to tax by the United States because it is engaged in a US business or (b) the corporation is subject to a comprehensive foreign income tax. A partnership will be a nonqualified entity unless substantially all of its income is allocated to partners that are subject to US or foreign taxes to a similar degree. Note that this definition of “nonqualified entity” could include even a domestic partnership in which US tax-exempt organizations (or low-taxed or non-taxed non-US investors) are significant investors.

    If an amount of deferred compensation is “not determinable” at the time it would otherwise be included in income, it will be included in income later when it becomes determinable, but will be subject to an interest charge and a 20 percent additional tax at that time.

    Compensation will be treated as subject to a substantial risk of forfeiture only if the rights to the compensation are conditioned upon the future performance of substantial services by any individual. This is intended to be a narrower definition of “substantial risk of forfeiture” than the definition applicable under other tax provisions. For example, performance-based forfeiture restrictions generally would not qualify as a substantial risk of forfeiture. Under an exception, however, compensation of a service provider that is determined by reference to the gain recognized on the disposition of a single asset (not including an interest in an investment fund or similar entity) will be treated as subject to a substantial risk of forfeiture until the date of disposition of that asset.

    The new law contains an exception for short-term deferrals: Compensation will not be treated as deferred compensation subject to the new law if the compensation is paid to the service provider within 12 months after the taxable year of the service provider in which the right to the compensation is no longer subject to a substantial risk of forfeiture.

    Existing deferrals of compensation that are not subject to the new rules solely because they are attributable to services performed before 2009 will eventually lose their “grandfather” status. In any event, these pre-2009 deferrals will be taxed in 2017 if they have not previously been taxed. Under regulations to be issued, existing deferred compensation arrangements can be amended, without penalty, to allow acceleration of payment of the deferred compensation to the date when they are required to be included in income under these rules. A provision granting an unlimited charitable deduction for contributions of deferred amounts, which had been proposed, was not included in the final legislation.